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2016
The Illusion of Fiscal Illusion in Regulatory Takings
Bethany Berger
University of Connecticut School of Law
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Bethany R. Berger, The Illusion of Fiscal Illusion in
Regulatory Takings, 66 Am. U. L. Rev. 1 (2016)
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ARTICLES
THE ILLUSION OF FISCAL ILLUSION
IN REGULATORY TAKINGS
BETHANY R. BERGER*
The main economic justification for compensating owners for losses from land use restrictions is based on a surprising mistake. Compensation is said to make governments internalize the costs of their actions and therefore enact more efficient regulations. Without compensation, the argument goes, governments operate under a fiscal illusion because, from their perspective, their actions are costless. The problem is that this argument makes no sense as a description of the actual costs to governments.
Taxation is the main way governments get revenue, and most taxes depend on the value of property and its permissible uses. If a government restricts land use so as to reduce the value of a parcel or the income produced by it, its residents, or its patrons, tax revenues should go down. If however, the restriction creates benefits, tax revenues should go up. While there are limitations to the accuracy and efficacy of the tax revenue signal, efficient regulations should have a net positive effect on governmental revenues, while inefficient ones should have a net negative effect. Fully compensating owners, in contrast, does not lead the government to accurately internalize societal
* Wallace Stevens Professor of Law, University of Connecticut School of Law. Thanks to Abraham Bell, Benjamin Barros, Hanoch Dagan, Nestor Davidson, Robert Ellickson, William Fischel, Eric Freyfogel, Jill Horwitz, James Hines, James Krier, Ruth Mason, Timothy Mulvaney, Hari Osofsky, Eduardo Pefialver, Jeremy Paul, Peter Siegelman, Christopher Serkin, Joseph William Singer, Laura Underkuffler, Hannah Weisman, and participants at the Progressive Property, Property Works in Progress, and Association for Law, Society, and Property workshops. Thanks also to Winter Pascual for excellent research assistance, and to the University of Connecticut Law School Foundation for support in completing this work.
AMERICAN UNIVERSITY LAW REVIEW
costs-it rather adds a new and much larger cost. Because this cost usually far exceeds revenue gains, governments may rationally forgo even efficient regulations. Owner compensation, in other words, does not correct fiscal illusion, it creates it.
Revealing the illusion of fiscal illusion leaves standing much older arguments that compensation is required as a matter offairness. But clearing away the main efficiency justification for one-to-one compensation permits clearer-eyed assessment of whether and to what extent fairness may require compensation and reveals that compensation measures in the name of efficiency may, in
fact,
undermine it.TABLE OF CONTENTS
Introduction ...... 22...
I. Fiscal Illusion Arguments and Their Flaws ... 7
A. Fiscal Illusion in Takings Scholarship ... ... 7
B. The Illusion of Fiscal Illusion in Brief.... ... 12
C. Conclusion ... 15
II. The Tax/Land Use Feedback Loop and Its Limitations... 16
A. Real Property Taxes ... ... 17
B. Income Taxes... 22
C. Sales Taxes ... 26
D. Conclusion ... 27
III. Do Governments Care About Revenue Impacts? .... ... 28
A. Governments Often Won't Care Much About Tax Revenues ... 28
B. Sometimes Governments Do Care About Tax Revenues-But That's Not Always a Good Thing... 31
C. Governments Do React to Full Compensation for Regulatory Restrictions-And That's Usually a Bad Thing... ... 34
D. Conclusion ... ... 37
IV. So What?-or, Focus on Fairness... ... 37
A. The Fairness Justification for Compensation .... ... 37
B. What Compensation Does Fairness Require? ... 40
C. Regulatory Takings and Murr v. Wisconsin .. ... 46
Conclusion ... ... 48
INTRODUCTION
For the first time in decades, the constitutional standard for requiring compensation for land use restrictions that leave title in the
THE ILLUSION OF FISCAL ILLUSION
original owner may be facing revision. In the last half century, the United States Supreme Court has affirmed a regulatory takings claim only once, in a 1992 case where the courts below found the restriction rendered the property at issue "valueless."' In January 2016, however, the Supreme Court granted certiorari in Murr v. Wisconsin,2 the first regulatory takings case to be decided by the Roberts Court.'
Because regulatory takings doctrine has little direct support in constitutional text or history, and earlier cases mostly rule against regulatory takings, the push to expand regulatory takings often rests on policy arguments.' This Article argues that the central efficiency
1. Lucas v. S.C. Coastal Council, 505 U.S. 1003, 1007 (1992). The regulation there prohibited any building at all on the owner's two beachfront lots for erosion control purposes, although all the neighboring lots already had homes on them. Id. at
1007-08. Even there the Court remanded to determine whether the economic
wipe-out was permitted under "background principles of nuisance and property law." Id. at
1031-32. Although the South Carolina Supreme Court found no such background
principle on remand in Lucas v. South Carolina Coastal Council, 424 S.E.2d 484, 486 (S.C.
1992), other state courts have exploited the loophole. See Michael C. Blumm & Lucus
Ritchie, Lucas's Unlikely Legacy: The Rise of Background Principles as Categorical Takings
Defenses, 29 HARV. ENvTL. L. REv. 321, 321, 323 (2005) (examining the use of background principles as categorical defenses to takings claims).
2. 136 S. Ct. 890 (2016), granting cert. in Murr v. State, No. 2013AP2828, 2014
WL 7271581 (Wis. Ct. App. Dec. 23, 2014) (per curiam). In the case below, the Wisconsin Court of Appeals held that a restriction on building on one of two neighboring lots owned by the same owners was not a per se taking of the owner's property). Murr, 2014 WL 7271581, at *8.
3. Several Roberts Court decisions have expanded the potential for takings claims when governments acquire or claim ownership of property. See Horne v.
Dep't of Agric., 135 S. Ct. 2419, 2426 (2015) (finding a taking in federal demand for personal property); Koontz v. St. Johns River Water Mgmt. Dist., 133 S. Ct. 2586,
2599, 2603 (2013) (holding that demands for money in exchange for a permit must be considered under the exactions analysis); Stop the Beach Renourishment, Inc. v.
Fla. Dep't. of Envtl. Prot., 560 U.S. 702, 715 (plurality opinion) (2010) (opining that a legislative orjudicial disposition transferring land ownership could be considered a taking). These decisions might be applied to future regulatory takings cases. The last case to directly consider a regulatory takings claim, however, was Lingle v. Chevron
US.A. Inc., decided on the eve of Roberts' ascension to the Court. 544 U.S. 528 (2005), abrogating Agins v. City of Tiburon, 447 U.S. 255 (1980). The Court in Lingle
unanimously narrowed the grounds for finding a regulatory taking, overruling a previous suggestion that regulatory restrictions must "substantially advance" their stated purpose. Id. at 531, 548.
4. See William Michael Treanor, The Original Understanding of the Takings Clause
and the Political Process, 95 COLUM. L. REv. 782, 783 (1995) (arguing that the original
understanding ofjust compensation did not include regulatory takings).
AMERICAN UNIVERSITY LAw REVIEW
argument for expansion-often dubbed "fiscal illusion"'-is without foundation. Understanding the illusion at the heart of fiscal illusion arguments for compensation places a sharper focus on the other arguments for and against broader compensation requirements.
The efficiency argument goes like this. If governments need not compensate owners for the loss in value caused by restricting land use, they need not internalize the costs of their actions.' As a result, governments will enact inefficient restrictions because they experience only the benefits of the land use restrictions.'
Governments operate under a fiscal illusion, in other words, because-from their perspective-their actions are costless.
The argument seems at first glance a common-sense extension of the cost-internalization argument often applied in analyses of private uses of land.' But it ignores fundamental differences with respect to governmental income streams that make the cost-internalization argument inapplicable. In fact, the assertion of fiscal illusion in regulatory restrictions is itself based on the illusion that governments do not already experience the costs of reductions in property value.
Governmental revenue is intimately tied to property value-quite directly for property taxes, and indirectly for most sales and income taxes.' Governments thus already feel the costs of actions that reduce the value or productivity of property but leave title in the hands of the owner. These costs will be balanced against any economic benefits the action creates in the jurisdiction, whether by increasing tax revenue or decreasing the costs of taxpayer-funded services associated with the property. Directly compensating owners for losses due to use restrictions, in contrast, will not lead the government to accurately internalize this loss. Rather, it will add a new and much larger cost to the action. If this additional cost is greater than the expected benefits of the land use measure, the government will
5. See Lawrence Blume & Daniel L. Rubinfeld, Compensation for Takings: An
Economic Analysis, 72 CALIF. L. REv. 569, 572-73, 621 (1984) (discussing "fiscal
illusion" in takings).
6. ROBERT COOTER & THOMAS ULEN, LAw AND EcoNOMIcs 186-87 (5th ed. 2009).
7. Id.
8. Nuisance laws, for example, are justified in part by the need to ensure that
parties whose land uses impinge on each other's take into account the social costs they create, so that the resulting combination of land uses maximizes the overall benefits from the use. See id. at 180-81; see also Boomer v. Atl. Cement Co., 257
N.E.2d 870, 873 (N.Y. 1970) (reasoning that the risk of permanent damages would
"be a reasonable[,] effective spur to research for improved techniques to minimize nuisance").
9. See discussion infra Part II.
[Vol. 66:1 4
2016] THE ILLUSION OF FIscAL ILLUSION 5 rationally decide to forgo the measure, even though the sum of the costs and benefits to the community would be positive. Requiring owner compensation does not correct the assumed fiscal illusion. It simply creates a new one.
The surprising mistake at the heart of many arguments about takings is the result of a broader phenomenon. As others have noted, law and economics scholarship too often analyzes problems as isolated transactions between parties, overlooking both the interdependence of multiple actors and the importance of their social and legal context."' In this case, by treating land use restrictions as bilateral transactions in which some property owners lose and others (or perhaps governments themselves) win, scholars have ignored the tax structure that results in governments experiencing these losses as well.
There are, of course, limitations to the accuracy and impact of the tax cost signal." The myriad qualifications, exceptions, and deductions in the tax system mean that there will almost never be a one-to-one correspondence between the tax received and the underlying value taxed. Nevertheless, the goal of the system is to achieve this correspondence, regardless of the extent to which the system actually realizes this goal. Practically, moreover, there is a rough relationship between tax returns and fluctuations in underlying value taxed, something lacking with respect to direct compensation to owners for claimed losses.
In addition, different levels of government will feel the impact of loss in property value more or less keenly." Local governments, which rely heavily on property taxes, will be most sensitive to land use restrictions that reduce the assessed value of the property; state governments will be less sensitive; and federal governments, even less. While state and federal governments will be more sensitive to effects on sales and income taxes, the relationship between land use regulation and such taxes is less readily calculated. Similarly, expenses associated with property use-such as funding costs of
10. See, e.g., Gideon Parchomovsky & Peter Siegelman, Selling Maybeny: Communities and Individuals in Law and Economics, 92 CALF. L. REV. 75, 77-78 (2004)
("[L]aw and economics scholars see victims in pollution disputes as acting independently of each other, with no interdependencies and no sense of social embeddedness.... [This] is a highly incomplete description of human behavior, one that can be misleading in some important settings.").
11. See discussion infra Part II.
AMERICAN UNIVERSITY LAW REVIEW
policing, providing public education, or remediating environmental degradation-are borne by different levels of government."
There is also a robust debate on whether and to what extent governments change their behavior in response to financial losses." Some argue that revenue generation does not motivate political actors in the same way that it motivates private individuals or firms." The central currency for politicians is votes, not dollars; while revenue losses-with resulting tax increases or service reductions-may affect political goals, they do not necessarily do so. In addition, the structure of government decision making often means that while one entity may be responsible for making land use decisions, another entity will be responsible for paying for them. But the premise of the fiscal illusion argument is that governments and their constituents need to feel both the costs and the benefits of governmental action in order to make efficient decisions. The point of this Article is that through the tax system, they already do."
Establishing that governments already feel the costs of land use restrictions does not mean that compensation is never necessary. Owners may still be entitled to compensation for their losses as a matter of fairness." But revealing the mistake on which many efficiency arguments for compensation are based facilitates clear-eyed assessments of fairness arguments for and against compensation. Mirroring the way that, on a societal level, tax revenues may both rise and fall as a result of land use restrictions, values of individual parcels may be both enhanced and depressed by land use laws. Demanding compensation when the same infrastructure restricts realization of
13. See DAvI BRUNORI, LOcAL TAx PoucY: A FEDERALIST PERSPECTIVE 46-47 (2d ed.
2007) (chronicling the stability of property tax and its use in financing public services). 14. See discussion infra Part III. Compare Daryl J. Levinson, Making Government
Pay: Markets, Politics, and the Allocation of Constitutional Costs, 67 U. CHI. L. REv. 345,
345 (2000) (arguing that governments do not respond to compensation requirements), with WILUAM A. FISCHEL, THE HOMEVOTER HYPOTHESIS: How HOME
VALUES INFLUENCE LocAL GOVERNMENT TAXATION, SCHOOL FINANcE, AND LAND-USE
POLICIES 39-40 (2001) (arguing that municipal governments are sensitive to compensation requirements).
15. Levinson, supra note 14, at 347.
16. Indeed, while some scholars challenge direct compensation as an effective prod for inefficient regulation, there is overwhelming evidence that zoning, the primary form of land use restriction, seeks to maximize tax revenue and limit demands on that revenue. See, e.g., ANN O'M. BOWMAN & MICHAELA. PAGANO, TERRA INCOGNITA: VACANT LAND AND URBAN STRATEGIES 55-59 (2004) (describing ways
municipalities shift land use strategies to maximize different forms of tax revenue).
17. See discussion infra Part IV.
THE ILLUSION OF FISCAL ILLUSION
those opportunities is sometimes, to borrow a phrase, a demand to socialize costs but privatize benefits.
Part I of this Article outlines the takings debate, how the concept of fiscal illusion has been employed in that debate, and how the link between tax revenues and land value undermines the concept. Part II provides more detail on the taxes impacted by land use regulation and discusses limitations to the link between taxation and land value. Part III discusses whether, and to what extent, political decision making is actually sensitive to these revenue impacts. Part IV suggests ways that exposing the illusion of fiscal illusion adjusts the focus on arguments for and against compensation as a matter of fairness and briefly shows how this analysis applies to Murr v. Wisconsin.
I. FISCAL ILLUSION ARGUMENTS AND THEIR FLAWS
Increasing efficiency is one of the core arguments for expanding the category of "takings," governmental impacts on property for which compensation is required.'" The central economic justification for compensation is that it will ensure that governments take into account the societal costs of their actions, a phenomenon often described as counteracting fiscal illusion. This justification is based on the premise that governments do not already experience the losses caused by actions that reduce property value. Because governments already lose revenue whenever their actions reduce the value of property or the activities associated with it, requiring direct compensation to the owner does not mitigate fiscal illusion. Rather, it creates new distortions that may deter efficient decision making. This Section briefly outlines the takings debate, the role of fiscal illusion arguments in this debate, and the fallacy of those arguments.
A. Fiscal Illusion in Takings Scholarship
Whether property has been "taken," so as to demand compensation, is the most palpable site of interaction between public and private definitions of property and is a fertile battleground for debates over the role of each. Since at least 1967, when Frank Michelman wrote his masterful exploration of the reasons for the compensation requirement, debates about takings have revolved around two policy goals: fairness, or respect for the rights of those affected by governmental action, and utility or efficiency, or
18. U.S. CONsT. amend. V ("[N]or shall private property be taken for public use, withoutjust compensation.").
AMERICAN UNIVERSITY LAW REVIEW
incentives for uses of property that will maximize public welfare." The sweeping nature of these goals, perhaps, explains why takings jurisprudence offers as many questions as answers. When and why
the government must pay compensation for actions that affect property has been described as a "muddle,"" "a secret code that only a momentary majority of the Court is able to understand,"" a candidate for the "doctrine-in-most-desperate-need-of-a-principle prize,"" and "like finding shapes in the clouds," a process that says "more about the observer than the clouds themselves.""
Despite this muddle, the broad contours of takings doctrine are easy to outline. When the government takes title to property or orders its permanent occupation by a stranger, there is almost always a taking, and the government must pay the owner the fair market value of the property acquired." Similarly, when the government renders real property valueless, there will generally be a taking." But where the government simply restricts the uses of property, even if the restriction significantly reduces the property's value, compensation will very rarely be required."
19. Frank I. Michelman, Property, Utility, and Fairness: Comments on the Ethical
Foundations of'Just Compensation"Law, 80 HARV. L. REV. 1165, 1214, 1219 (1967).
20. Carol M. Rose, Mahon Reconstructed: Why the Takings Issue Is Still a Muddle, 57
S. CAL. L. REV. 561, 561 (1984).
21. Michael A. Heller &James E. Krier, Commentary, Deterrence and Distribution in
the Law of Takings, 112 HARV. L. REV. 997, 997 (1999).
22. Jed Rubenfeld, Usings, 102 YALEL.J. 1077, 1081 (1993).
23. Christopher Serkin, The Meaning of Value: Assessing just Compensation for
Regulatory Takings, 99 Nw. U. L. REV. 677, 741 (2005).
24. Loretto v. Teleprompter Manhattan CATV Corp., 458 U.S. 419, 441 (1982) (holding that permanent physical occupations, no matter how small, require compensation). The Supreme Court has recently held that this principle usually applies to personal as well as real property. Home v. Dep't of Agric., 135 S. Ct. 2419,
2426 (2015).
25. See Lucas v. S.C. Coastal Council, 505 U.S. 1003, 1031-32 (1992) (holding
that economic wipe-outs are per se compensable unless the regulations merely implemented "background principles of nuisance and property law").
26. William A. Fischel, Why Are Judges So Wary of Regulatory Takings?, in PRIVATE PROPERTY IN THE 21ST CENTURY: THE FuTuRE OF AN AMERICAN IDEAL 50, 55 (Harvey M. Jacobs ed., 2004) (stating that under the Penn Central test, the "bottom line is that the complaining property owner almost always loses"); see, e.g., Tahoe-Sierra Pres. Council, Inc. v. Tahoe Reg'1 Planning Agency, 535 U.S. 302, 306, 319-20 (2002) (finding no taking when temporary moratoria prevented any development of property for more than two years); Penn Cent. Transp. Co. v. City of New York, 438
U.S. 104, 116-17, 138 (1978) (finding no taking in the implementation of a
landmark protection law preventing Grand Central Station from selling its air rights for millions of dollars).
THE ILLUSION OF FISCAL ILLUSION
It is this last thread of the doctrine that has come under attack as furthering fiscal illusion. The argument goes like this: if governments do not have to pay owners for the costs of actions that reduce the value of property, they will act as though those actions are costless. The result will be overregulation or restrictions on uses of property whose net effect is to detract from public welfare. If, however, governments compensate owners for their losses, they will internalize the costs of
their actions and make more efficient decisions."
Although scholars made this argument in earlier articles," Lawrence Blume and Daniel Rubinfeld dubbed it "fiscal illusion" in
1984, and the title has stuck.` This use of the phrase is somewhat different from its use in the public choice literature that coined it, where fiscal illusion primarily describes the failure of voters to understand the cost of government services that they are already in fact paying for through taxes or other means."' In takings literature, in contrast, "fiscal illusion" seems instead to mean that the government does not take into account the societal costs of governmental actions unless the government itself pays for them:
[A] governmental regulatory body will over- or under-regulate if it does not consider all budgetary and social costs. The actual result depends upon the distribution of individual tastes and political influence within the community. As applied to the land market, if
the governmental body responsible for zoning decisions does not pay compensation, it cannot make socially beneficial decisions. In other words, the governmental body is subject to "fiscal
27. Throughout the literature, and in this Article as well, "efficiency" generally refers to Kaldor-Hicks efficiency, meaning that the regulation generates benefits to society as a whole that outweigh its costs, not that the action makes all those affected
by it better off. See COOTER & ULEN, supra note 6, at 43-44; Jules Coleman, The Normative Basis of Economic Analysis: A Critical Review of Richard Posner's The
Economics of Justice, 34 STAN. L. REv. 1105, 1106-07 (1982) (book review) (discussing Kaldor-Hicks and Pareto superiority definitions of efficiency); Thomas S. Ulen, Commentary, Professor Crespi on Chicago, 22 L. & Soc. INQUIRY 191, 193 (1997) (noting that law and economics scholars have made Kaldor-Hicks the "default" criterion for efficiency).
28. See Robert C. Ellickson, Suburban Growth Controls: An Economic and Legal Analysis, 86 YALE L.J. 385, 420 (1977) (arguing that compensation will lead municipal
officials to conduct more thorough cost-benefit analyses of alternate measures); Michelman, supra note 19, at 1218 (arguing that compensation may provide assurance that "society deems the measure ... efficient").
29. Blume & Rubinfeld, supra note 5, at 621.
30. See JAMES M. BUCHANAN & RICHARD E. WAGNER, DEMOCRACY IN DEFIcrr: THE PoLmcAL LEGACY OF LORD KEYNFs 128-30 (1977) (arguing that voters make fiscal choices in response to the perceived cost of public services rather than their actual costs).
AMERICAN UNIVERSITY LAW REVIEW
illusion." Fiscal illusion arises because the costs of governmental actions are generally discounted by the decisionmaking body unless they explicitly appear as a budgetary expense.31
Whether called fiscal illusion or cost internalization, the concept is a polestar of economic analysis of takings. The leading law and economics textbook, for example, summarizes it as follows:
Obviously, the noncompensability of regulations gives government officials an incentive to overregulate, whereas the compensability of takings makes governmental officials internalize the full cost of expropriating private property. If the state need not compensate for restrictions, then it will impose too many of them. If there are too many restrictions, then resources will not be put to their highest-valued use. Thus, uncompensated restrictions result in inefficient uses.3 2
Compensation, in contrast, provides a check to ensure that governments will enact only efficient actions. Richard Epstein puts it bluntly: "If by chance, the diffuse social gains do outweigh the localized costs, then the 'winners' should be able to push the condemnation measure through, with compensation."3 3
Richard Posner, one of the founding figures in law and economics, summarizes the argument as follows: "The simplest economic
31. Blume & Rubinfeld, supra note 5, at 621 (footnotes omitted). Although
those who argue that compensation will lead to more efficient results do sometimes argue that the efficiency-generating impact of the results stems from voter pressure, they generally do not incorporate the public choice insight that the form-rather than amount-of public expenditures is crucial. See Pennell v. City of San Jose, 485
U.S. 1, 22 (1988) (Scalia,
J.,
dissenting) (arguing that uncompensated regulation permits wealth transfer "to be achieved 'off budget,' with relative invisibility and thus relative immunity from normal democratic processes"). In public choice literature, however, full compensation may be consistent with fiscal illusion depending on whether the connection between compensation and voter tax bills is sufficiently salient. See Wallace E. Oates, On the Nature and Measurement ofFiscal Illusion: A Survey,in TAXATION AND FISCAL FEDERALISM: ESSAYS IN HONOUR OF RUSSELL MATHEWS 65, 65-67 (Geoffrey Brennan et al. eds., 1988) (summarizing the fiscal illusion thesis).
32. COOTER & ULEN, supra note 6, at 186--88. Cooter and Ulen then go on to
state moral hazard problems with across-the-board compensation. See DAVID A. DANA & THOMAS W. MERRILL, PROPERTY: TAKINGS 41-46 (2002) (calling "fiscal illusion," along with fairness and process concerns, one of three central arguments for compensation); WILLIAM A. FISCHEL, ZONING RULES! THE EcoNOMICS OF LAND USE
REGULATION 105 (2015) ("[Tlhe appeal of regulatory takings to economists is that it
makes regulators pay close attention to the economic consequences of their actions"); STEVEN SHAVELL, FOUNDATIONS OF ECONOMIC ANALYSIS OF LAW 127-29
(2004) (summarizing and critiquing the cost internalization argument).
33. RICHARD A. EPSTEIN, SUPREME NEGLECT: HOW TO REVIVE CONSTfrUTIONAL
PROTECTION FOR PRIVATE PROPERTY 119 (2008).
THE ILLUSION OF FISCAL ILLUSION
explanation for the requirement of just compensation is that it prevents the government from overusing the taking power.""
Scholars have raised important qualifications of the efficiency-generating results of compensation standing alone. In some cases, high transaction costs undermine the efficiency benefits of compensation." Compensation may also create a moral hazard by effectively insuring those engaging in potentially harmful behavior, leading them to invest without regard to the risk of government prohibition." Further, cost internalization does not require-and is sometimes undermined by requiring-governments to pay owners, rather than putting the money into some other worthy fund."
Scholars have also raised more fundamental challenges to the efficiency argument for compensation. One such challenge is that governmental actors are far more concerned with getting and maintaining political power-a goal that needs not have a direct connection with revenue going out and has an even more tenuous connection with revenue coming in." Another challenge is that measuring the impact of government actions by their monetary costs and benefits may miss less monetizable impacts, such as the harms of racism or pollution, the benefits of an old growth forest, or the importance of preserving existing communities."
34. RicHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 58 (4th ed. 1992).
35. See Michelman, supra note 19, at 1214-15 (discussing "settlement costs" for
paying compensation).
36. Louis Kaplow, An Economic Analysis of Legal Transitions, 99 HARv. L. REv. 509,
537-40 (1986).
37. See Heller & Krier, supra note 21, at 1000 (arguing that at times efficiency
would be better served if governments "pay deterrence damages into a special fund, or even into general revenues").
38. See Daniel A. Farber, Public Choice and just Compensation, 9 CONST. COMMENT. 279, 280 (1992) (asserting that compensation may sometimes decrease public opposition, thereby reducing incentives for officials to enact only efficient measures); Levinson, supra note 14, at 345 (arguing that government actors are less responsive to financial factors than political ones); see also FISCHEL, HOMEOWNER HYPOTHESIS, supra note 14, at 39-40 (discussing the different political considerations of local versus larger governments). For a recent empirical study showing that increasing compensation requirements did not deter eminent domain in Israel, see Ronit Levine-Schnur & Gideon Parchomovsky, Is the Government Fiscally Blind? An
Empirical Examination of the Effect of the Compensation Requirement on Eminent Domain Exercises, 45J. LEGAL STUD. (forthcoming 2016), http://papers.ssrn.com/sol3/papers
.cfm?abstract id=2621778.
39. See generally Joseph William Singer, Democratic Estates: Property Law in a Free
and Democratic Society, 94 CORNELL L. REv. 1009, 1035-38 (2009) (discussing limitations of the efficiency approach).
AMERICAN UNIVERSITY LAw REVIEW
These arguments, however, have largely led economics-minded authors to develop proposals tinkering with when and how much compensation should be required rather than to discard reliance on the concept.0 Despite decades of critique, therefore, fiscal illusion remains "perhaps the most common economic explanation of the constitutional mandate ofjust compensation.""
B. The Illusion ofFiscal Illusion in Brief
Missed in all the writing on fiscal illusion in regulatory takings is that the concept makes no sense as a description of the actual costs to governments. Taxation is the main way governments get revenue, and most taxes depend on the value of property and its permissible uses. If governments restrict property use so as to reduce the value of the property or the income produced by it, its residents, or its patrons, they already feel the loss in their budgets. If the restriction enhances the value of property or limits the taxpayer-funded services associated with it, the government will experience those benefits as well. Efficient regulations, therefore, should have a net positive effect on governmental revenues, while inefficient ones should have a net negative effect. Compensation will only undermine accurate internalization of the societal cost of regulation.
This argument has less force with regard to physical takings. When the government physically acquires the property of another, it actually gets the property itself. Therefore, the government has gained an asset with an easily identifiable market value and will roughly break even if it compensates the owner for the same amount. Conversely, if the government need not pay
40. See Timothy J. Brennan & James Boyd, Political Economy and the Efficiency of
Compensation for Takings, 24 CoNTEMP. EcoN. POL'Y 188, 200 (2006) (arguing that
whether compensation is paid should depend on the relative political power of beneficiaries and land owners); Thomas J. Miceli & Kathleen Segerson, Regulatory
Takings: When Should Compensation Be Paid?, 23 J. LEGAL STUD. 749, 750-51 (1994)
(proposing that compensation should be owed only if the land was used efficiently before regulation or if the government passed the regulation inefficiently); Paul Pecorino, Optimal Compensation for Regulatory Takings, 13 AM. L. & ECON. REv. 269, 271,
274 (2011) (positing that compensation should depend in part on the distortionary impact of taxes and the level of governmental bias).
41. Abraham Bell & Gideon Parchomovsky, The Hidden Function of Takings
Compensation, 96 VA. L. REv. 1673, 1682 (2010).
42. The government will only "roughly break even" because some additional costs are not included here, such as the cost of finding the owner and setting compensation, and the loss of tax revenue on the property. But except for very miniscule governmental invasions-see, for example, Loretto v. Teleprompter
THE ILLUSION OF FISCAL ILLUSION
compensation, it collects a windfall and may have an economic incentive to overtake." Compensation thus makes more sense as a measure to discourage inefficiency in physical takings-but those are the actions for which compensation is already clearly required anyway.
In contrast, where the owner retains title to the property, taxation means that the government already feels her pain. This concept is clearest for property taxes, which are based on a property's assessed value. Because property is assessed at its highest and best legal use, if a regulation prohibits its most lucrative use, then its assessed value should decrease, which should reduce taxes from the property." But
Manhattan CATV Corp., 458 U.S. 419 (1982) (property occupied had almost no
value)-the value of the property itself should be so much larger that transaction costs and lost tax revenues are relatively insignificant in the overall transaction.
43. One could make a similar argument with respect to land use restrictions. Covenants are private agreements for land use restrictions and include some of the same things-commercial use restrictions, single family home requirements, etc.-included in land use laws. Why, when the government enacts such a restriction, aren't they acquiring the value of the equivalent private covenant? There are practical and theoretical objections to this argument. The practical objection is that placing a dollar value on such restrictions is far more difficult than valuing physical property. Covenants are usually created as part of an exchange of land or as a voluntary exchange for tax benefits, so there are few comparable market sales of such restrictions. Indeed, recent investigations suggest donations of such restrictions are
routinely overvalued. SeeJosh Eagle, Notional Generosity: Explaining Charitable Donors'
High Willingness to Part with Conservation Easements, 35 HARv. ENVTL. L. REv. 47, 70 &
n.122 (2011) (arguing that tax deductions for conservation easements overvalue the easements); Wendy C. Gerzog, Alms to the Rich: The Fagade Easement Deduction, 34 VA.
TAx REv. 229, 229 (2014) (contending that the facade easement tax deduction overvalues the easements); see alsoJOAN YOUNGMAN, A GOOD TAx: LEGAL AND PoLIcY ISSUES FOR THE PROPERTY TAx IN THE UNITED STATES 131 (2016) (discussing the difficulty of valuing conservation easements). The theoretical objection is that physical property, once taken, belongs to the government in a way that a regulatory restriction simply does not. Land, if not valuable for the use for which the government took it, may be sold or put to another use. A land use restriction simply cannot be repurposed in this way-if the restriction turns out not to be worth the costs it imposes, the government's only option is to repeal it, retaining no future value to enjoy. Moreover, the benefit of the use is generally not experienced by the government itself, but by owners of other property. Situations in which the restriction is the equivalent of an easement for the government's own use are far more likely to be held to be takings. SeeJoseph L. Sax, Takings and the Police Power, 74 YALE L.J. 36, 47 (1964) (positing that "state courts have quite uniformly rejected" appropriations in the guise of restrictions "and required the payment of compensation").
44. The municipality might make tip the difference by increasing the local tax rate, but such increases would be uniform across properties, so that the yield from the restricted property would still be proportionately lower.
AMERICAN UNIVERSITY LAW REVIEW
land use restrictions also affect income and sales taxes." If residential purposes are restricted or the property becomes less desirable for them, fewer or less wealthy people, who will pay lower income taxes, will live there. If lucrative industrial or commercial purposes are prohibited, corporate and employee income taxes will go down. Finally, if retail purposes are restricted or become less profitable on the property, sales taxes will drop accordingly. As discussed in the next Section, a number of factors distort the cost signals of these taxes and whether the same government that enacts the land use restriction is the one that feels the restriction's effects. Despite this, some government always and already feels the cost of restrictions on property.
The cost experienced by the government is, of course, not the same as that experienced by the property owner. But neither is the benefit. Both the cost and the benefit reflect the percentage of value reached by taxation, and (assuming that tax rates accurately capture value and income, an assumption discussed further below) the sum should reflect the overall economic impact of the action on social welfare. Requiring governments to compensate owners directly for the loss, in contrast, adds an extraneous cost that is usually significantly larger than, and has little to do with, the social welfare impact of the restriction and may therefore deter otherwise efficient regulations.
Consider this extremely simplified example: assume that residents of Anytown are taxed at 1% of the value of their properties annually, and that a new zoning restriction lowers the fair market value of Blackacre by 20%, from $100,000 to $80,000. The owner of Blackacre immediately loses $20,000 in value, while the government will only lose $200 in revenue in the first year reflecting this change. If the zoning restriction raises the value of surrounding properties, taxation will also only capture that value at a rate of 1% a year. Say the zoning restriction raises the value of twenty surrounding properties by $5000 each, for a total of $100,000, or a net gain of $80,000 in property value. The government will recoup $1000 per year of this benefit, for a net gain of $800. Thus, although the net impact of the property restriction on social welfare is not the same as the impact on governmental revenue, the coefficient will be the same for each. An overall efficient change will have an overall positive impact on governmental budgets, while an overall inefficient change will have a negative impact.
45. See BOwMAN & PAGANO, supra note 16, at 55 (discussing land use strategies to
maximize particular kinds of taxes).
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Now imagine the impact if Anytown is forced, as advocates of expansion of regulatory takings urge, to pay the owner of Blackacre for the reduction in value to the property. In the first year after the restriction, the government loses both the reduction in taxable value ($200) and the cost of compensation ($20,000), but only gains $1000, for a net loss of $19,200. Although the overall benefit will still be $800 for future years, it will be twenty-five years before the government breaks even on this restriction, by which point the positive impact on governmental revenue may well be wiped out by the cost of financing the initial $20,000 compensation.
Across the range of cases, the length of time necessary for a government to reap the benefits of an efficient restriction will depend on multiple factors: the tax rate, the amount of compensation necessary, the cost of generating the initial lump sum award to the property owner, any independent change in property value, and the relative gains and losses from the restriction.46 But, except in extreme cases, the governmental incentives are very different in a regime that requires compensation for land use restrictions. A restriction that is efficient as a matter of overall social welfare no longer makes as much sense as a matter of governmental revenue. A government motivated by its budget might well choose to forgo the restriction in order to avoid paying compensation, and property regulation would be less efficient as a result.
This hypothetical example does not take into account the transaction costs in finding those experiencing loss as a result of the restriction, determining the amount of the loss, and paying the compensation. All of these additional costs will make restricting land use with a compensation requirement an even less attractive proposition." In contrast, there are no additional transaction costs involved in taxation. Although setting and collecting taxes is costly and cumbersome, both cost and cumber exist whether or not compensation is required for regulatory restrictions.
C. Conclusion
Requiring compensation for regulatory restrictions does not dispel fiscal illusion-it creates it. Fully compensating the owners whose property loses value as a result of land use restrictions has nothing to
46. See Pecorino, supra note 40, at 274 (showing the costs of fulfilling
compensation requirements).
47. Cf Michelman, supra note 19, at 1214-15, 1214 n.99 (discussing ways that
finding and settling claims for compensation affect a measure's gains).
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do with accurate balancing of costs and benefits. Governments do not receive the value that is lost by the owner directly; instead, they receive only a fraction of that value through the amount recouped in increased tax revenues or saved in taxpayer-funded services. But governments also experience a decrease in revenues proportionate to any losses property owners experience. In a nondiscriminatory and accurate system of taxation, actions that have a positive economic impact will increase governmental revenue while those that have a negative impact will decrease revenue. To the extent governments react to these revenue changes, they do not need compensation requirements to dispel the illusion that land use restrictions are costless. Adding a compensation requirement, in contrast, distorts the cost signal that taxation already provides.
Will this realization make governments enact only measures that maximize economic welfare? Not necessarily. Sadly, governmental actors, like the rest of us, lack crystal balls foretelling which measures will produce wealth and prosperity. All they can do is guess, and their guesses are sometimes very bad. Also, governmental actors, perhaps even more than the rest of us, are motivated by many things beyond maximizing revenues." They may support measures that are bad economics because they are good politics and will win votes even if they lose money. They may also support measures that serve policy goals without regard to their ultimate economic impact. Economic arguments are helpful in environmental protection or affordable housing debates, for example, but are less important in securing their passage than other convictions. But the fiscal illusion argument is built on the assumption that policymakers should and do care about maximizing fiscal returns. Taken on its own terms, the argument makes no sense.
II. THE TAX/LAND USE FEEDBACK LOOP AND ITS LIMITATIONS Governments raise revenue in many ways, and property use affects most of them. Property taxes are affected by the value of the property, sales taxes by the sales connected with the property, and income taxes by how attractive the property is for profitable businesses and higher-income employees and residents. As legal changes affect the importance of any one of these forms of taxation, governments turn to others to make up lost revenue. Limits on municipal property taxation, for example, lead local governments to
48. See discussion infra Part III.
THE ILLUSION OF FISCAL ILLUSION
compete for local sales or income taxes and other fees, or to rely on state revenues, themselves derived from sales and income taxes, to make up shortfalls."
Changes in property value have different impacts on different taxes and governments. Municipal governments, which enact most land use restrictions, are most sensitive to changes in property taxes, while federal and state governments are most sensitive to changes in income taxation. By contrast, state and, to a lesser extent, municipal governments are most sensitive to changes in sales taxes. Features of various tax systems may also distort the accuracy with which assessment value reflects property value. Nevertheless, this section shows that various taxes should ultimately communicate much of the economic impact of land use restrictions to each of the jurisdictions in which the property is located.
A. Real Property Taxes
The impact of land use restrictions has the most direct and transparent effect on real property taxes. Real property taxes are levied in every state and are a tremendously important source of revenue."' Property taxes range from over 40% of all revenue in many northeastern states to only 11% of revenue in Alaska, which relies heavily on mineral extraction fees and royalties." Property taxes are particularly important for local governments: property taxes make up over 70% of local tax revenue." Although both states and municipalities rely more heavily on other sources of revenue than they did before the property tax revolts of the 1970s, property taxes remain the most significant source of tax revenue for state and local governments."
Property taxes are a function of the assessed value of the property at issue, multiplied by the assessment rate, multiplied by the rate at
49. See infra notes 77-83 and accompanying text.
50. YOUNGMAN, supra note 43, at ix (stating that " [t] he property tax is a mainstay of independent local revenue in this country," whose annual totals far exceed the corporate income tax); Ryan Forster & Kail Padgitt, Where Do State and Local
Governments Get Their Tax Revenue?, 242 FIScAL FAcr 1, 4-5 (2010), http://taxfoundation.org/sites/taxfoundation.org/files/docs/ff242.pdf.
51. Id.
52. SeeJEFFREY L. BARNETr ET AL., 2012 CENSUS OF GOVERNMENTS: FINANCE-STATE
AND LOcAL GOVERNMENT SUMMARY REPORT 3 (2014), http://www2.census.gov/govs/1 ocal/summary-report.pdf (reporting that property taxes made up 73.5% of local tax revenue in 2012).
53. See BRUNORI, supra note 13, at 55, 58 (discussing the decline in reliance on
property taxes).
AMERICAN UNIVERSITY LAw REVIEW
which the value is taxed, called the millage rate. Assessment is most often conducted by municipalities, although states have varying levels of control and involvement in assessment." Assessment itself is based on the sales prices of comparable properties, replacement cost, or income stream of the property, or some combination of the three." With the exception of replacement cost, each of these factors is directly affected by restrictions on the use of the property. Indeed, claims for takings compensation for regulatory restrictions generally rest on either the reduced expected sales price or income stream from the property.
A number of factors affect the extent to which assessed value accurately reflects the impact of land use restrictions. Some factors are the result of various exemptions and limitations on property taxes imposed as a result of widespread protests against property taxes in the 1970s." Many of these measures draw differences between business and residential, particularly owner-occupied, properties.
More than half of states have homestead exemptions reducing the taxes on properties occupied as the owner's primary residence.' Many other states prevent property taxes from exceeding a certain percentage of the owner's annual income." A number of other states
54. E.g., MANDY RAFOOL, A GuIDE TO PROPERTY TAxES: AN OVERVIEW 8-9 (2002). 55. Id. at 7-8 (breaking down the assessment responsibility in each state).
56. Jennifer J.S. Brooks & Ronald J. Schultz, Market Theory: An Approach to Real Property Valuation for State and Local Tax Purposes, 45 TAx LAW. 339, 339-40 (1992).
57. See, e.g., Palazzolo v. Rhode Island, 533 U.S. 606, 616 (2001) (alleging takings
based on different in value if he could fill in and develop his wetland property versus its value with the restriction); Vill. of Euclid v. Ambler Realty Co., 272 U.S. 365, 384
(1926) (arguing that regulation amounted to a taking because property was worth $10,000 per acre if it could be used for industrial purposes versus $2500 per acre if
restricted to residential purposes).
58. Property taxes are extremely visible to taxpayers. Unlike most income taxes,
property taxes are not deducted from an income stream or calculated as a portion of an overall tax bill. Rather, owners receive a separate bill for property taxes, often
twice a year. If individuals choose not to pay, governments may foreclose on their homes. Property taxes also need not reflect ability to pay; those who own property as a residence receive no additional income when the value of their property increases. Particularly for those on a fixed income, increased taxes as a result of increased assessed value impose a serious hardship. In response to such inequities and other protests, states have enacted a number of measures that distort the relationship between taxation and assessed value. See BRUNORI, supra note 13, at 56-58; Edward A.
Zelinsky, The Once and Future Property Tax: A Dialogue with My Younger Self 23
CARDozo L. REV. 2199, 2201-03, 2216 (2002) (discussing changes to property tax).
59. BRUNORI, supra note 13, at 58, 63-64.
60. Id. at 63-64. 61. Id. at 64.
THE ILLUSION OF FISCAL ILLUSION
grant deferrals of property taxes for elderly or disabled owners until the property is sold, although few of those eligible take advantage of the deferrals." Many states also create different assessment rates for different kinds of properties, often taxing homeowners and farmers on a smaller percentage of the assessed value than that on which businesses are taxed."
Each of these measures might be expected to make governments less sensitive to measures that affect the assessed value of residential, as opposed to business, properties. Nevertheless, governmental reliance on residential property taxes has only grown since the 1970s." Factors behind this trend may include greater difficulty in assessing business property, greater reliance by businesses on equipment rather than real property, and negotiated tax reductions for new businesses expected to contribute to economic development65 So although changes in value may affect the tax levy on different kinds of property in different ways, restrictions that affect the value of different kinds of properties will in most cases also affect property taxes.
An additional limitation lies in the accuracy of assessed value. Because assessments rely on the assessor's estimate of what the property will sell for, and because individual properties may differ in many ways even from neighboring properties, there is much room for error. Inconsistencies in assessed values are notorious." Some of these differences are random. Others are the result of systemic differences. Studies have found systemic undervaluation of high value residences and overvaluation of low cost properties; lower valuation of owner-occupied versus rental properties; and even overvaluation of properties in majority-minority versus majority-white neighborhoods."
If there were truly no relationship between assessed value and true value, there would be no reason for property taxes to reflect the impact of land use restrictions. But, of course, there is a significant
62. Id. at 64-65.
63. RAFoOL, supra note 54, at 8.
64. BRUNORI, supra note 13, at 58; see also Byron Lutz et al., The Housing Crisis and
State and Local Government Tax Revenue: Five Channels, 41 REGIONAL Sci. & URB. ECON.
306, 308 (2011) (reporting that residential property makes up about 60% of assessed
value).
65. BRUNORI, supra note 13, at 58.
66. Id. at 57; see also Lee Harris, 'Assessing' Discrimination: The Influence of Race in Residential Property Tax Assessments, 20 J. LAND USE & ENvrL. L. 1, 2 (2004) (discussing
the systematic differences in property valuation across racial lines).
67. See Harris, supra note 66, at 12 (examining the racial dynamics underlying the disparities in property tax assessments).
AMERICAN UNIVERSITY LAw REVIEw
relationship, even if the relationship is not perfect.' The kind of differences caused by land use restrictions are also relatively easy to assess. Unlike the different feel and attractiveness from one block to another, prohibitions on building more than one home per acre, for example, or on industrial use, have clear and comparatively easy to monetize impacts." Land use restrictions also do not fall within the known categories of systemic overassessment, such as low value, commercial, renter-occupied properties."o
Another potential limit on the sensitivity of governmental decision makers to changes in property value comes from lag times between assessments. If property need not be reassessed regularly, governments may enjoy long periods without experiencing revenue changes from reductions in property value. Although eventually the change will affect tax revenues, in the interim the situation might appear to be closer to the something-for-nothing that advocates of the fiscal illusion construct posit. If the cost is delayed, however, so is the benefit; the government will not experience any tax gains from increased value of other properties until reassessment is complete either." Widespread decreases in assessment times over recent decades also mitigate this problem.2 Today, reassessment is mandated every year in twenty-five states; in most others, reassessment is required between every two and four years." There are outliers-Rhode Island requires reassessment every ten years; North Carolina, every eight years; and California, under Proposition 13, requires reassessment only when property is sold." But in most states owners are entitled to regular reassessments.
The availability of appeals provides another safeguard to ensure that assessments reflect the impact of restrictions that decrease
68. See Justin M. Ross & Wenli Yan, Fiscal Illusion from Property Reassessment? An
Empirical Test of the Residual View, 66 NAT'L TAxJ. 7, 9 (2013) (noting high correlation
between property tax revenues and housing prices).
69. In fact, state and local governments regularly do monetize such impacts by
reducing property taxes on land dedicated to open space, wilderness, or farming purposes. Because such easements are only exchanged with governments or charities, however, and not on the open market, there is concern that such easements are overvalued. Eagle, supra note 43, at 69-70.
70. If anything, downzoning, restrictions on commercial uses, and environmental
protections are more likely in the high value, owner-occupied areas that are more likely to be underassessed already. Harris, supra note 66, at 12.
71. RAFOOL, supra note 54, at 6.
72. Id. 73. Id. at 6-7.
74. Id.
[Vol. 66:1 20
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property value. Assessment appeals are rare-occurring in just 2% of assessments according to one early study"-but are low cost and readily available to the disgruntled property owner." For the owner significantly aggrieved by a land use restriction, the assessment appeal presents an easy partial remedy.
The most important limitation of the impact of land use restrictions on property taxes is that they are primarily municipal taxes. Many states collect taxes on particular kinds of property, such as railroad rights-of-way;n a number commandeer some municipal taxes to fund school revenue equalization schemes; and a few collect and distribute most property tax revenues directly." In general, however, property taxes fund municipal budgets, not state ones, and certainly not federal ones. Municipal governments will, therefore, be most sensitive to the impact any land use restrictions have on property taxes, state governments less so, and federal governments hardly at all.
But what one level of government loses, other governments and other tax sources must make up." In particular, when local revenues decrease, state support increases. The limitations on property taxes in recent decades have been accompanied by sharply increased state support for local governments." States, in turn, have increased their reliance on other forms of revenue, particularly individual and corporate income taxes."' Still, property taxes compete with sales taxes
75. THEODORE REYNOLDS SMITH, REAL PROPERTY TAXATION AND THE URBAN
CENTER: ACASE STUDY OF HARTFORD, CONNECICUT 46 (1972).
76. See RAFOOL, supra note 54, at 11 (describing the elements of the appeals
process common to most states, including that property owners generally may simply
call the assessor's office).
77. Id. at 13. 78. Id. at 4-5.
79. See generally John Joseph Wallis, A History of the Property Tax in America, in
PROPERTY TAXATION AND LOcAL GOVERNMENT FINANCE: ESSAYS IN HONOR OF C. LOWELL HARRIss 123, 127-28 (Wallace E. Oates ed., 2001) (describing a shift between different types and levels of taxation over U.S. history).
80. See BRUNORI, supra note 13, at 65-66 (discussing the significant increase in
state funding for local schools over the past quarter century).
81. Between 1948 and 2010, sales taxes as a percentage of state and local
revenues have remained almost the same. See Liz Malm & Ellen Kant, The Sources of
State and Local Tax Revenues, TAx FOUND. tbl.2 (Jan. 28, 2013), http://taxfoundation.org/article/sources-state-and-local-tax-revenues (showing that individual and corporate income taxes increased from 8.5% of state and local revenues to 23.9% between 1948 and 2010).
